Europe Attempts to Learn its Lessons from the Sovereign Debt Crisis and Guard Against Rating Procyclicality

The European Sovereign debt crisis, which engulfed the EU after the Financial Crisis, left an indelible mark on the structure and mentality of those charged with leading the bloc. Now, as the bloc faces yet another crisis in the form of the COVID-19 pandemic, it appears that the leaders of the EU and, in particular the ECB (European Central Bank), have learned their lessons from 2012 and are taking proactive actions against the coming wave of downgrades. However, have they really learned their lesson? Also, what are the risks that the EU is opening itself up to, financially, as well as politically? In this post we will review the unscheduled announcement recently by the ECB that it will now be accepting the bonds of so-called ‘fallen angels’ as collateral.

It is being widely reported in today’s business press that the ECB will, as long as a so-called ‘fallen angel’ was deemed investment-grade on and before the 7^th April and that they remain as BB-rated (or the equivalent), accept those bonds as collateral within the ECB’s ‘collateral framework’. This, essentially, refers to the process whereby the ECB will allow for credit to enter the financial system, but provides the ECB with some level of protection. The ECB itself declares that ‘the collateral framework of the central bank is therefore important not only for risk protection and the feasibility of central bank credit operations, but also for financial conditions, financial stability and the transmission mechanism of monetary policy, in particular in stress situations’. However, how does the ECB know what collateral is worthy of being used within that framework? There are a number of options available to them, but one of the more common measures is a bond’s credit rating, as provided by the leading credit rating agencies.

With the cut-off being the so-called ‘investment-grade’ demarcation that all rating agencies have, the situation is rather simple. However, in the current situation (as we have spoken about before here in Financial Regulation Matters), there are a number of bonds and entities that sit either on the precipice, or have fallen below it. Those that have fallen below it are deemed ‘fallen angels’. With the rating agencies being criticised for rating potentially suspect entities as investment-grade in the ‘good times’ because those entities pay the agencies for their ratings, the natural knock-on effect of that is that when times go bad, those that have had their ratings inflated will quickly drop into non-investment grade; the result of this is that it is both harder for those entities to access credit, and that their bonds become ineligible to be used as collateral for other things. One of those things is accessing credit from central banks. However, in the current climate it is crucial that central banks maintain their function and maintain a level of liquidity within the financial system. So, to that end, the ECB held an unscheduled call of the ECB’s governing council on Wednesday in order to approve an alteration in their processes; that alteration was that now the ECB will accept the bonds of fallen angels as collateral within its framework. Furthermore, the ECB announced that ‘the ECB may decide, if and when necessary, to take additional measures to further mitigate the impact of rating downgrades, particularly with a view to ensuring the smooth transition of its monetary policy in all jurisdictions of the euro area’. Whilst a decision like this would not have been made hastily, it does appear to have a sentiment of haste about it. Why? The financial press have probably rightly made the connection between this move and the fact that S&P is due to deliver its next rating action on Italy and its sovereign bonds on Friday, which the prediction being that it will be going downwards. Although the two elements are separate, in that the ECB is providing waivers for the sovereign debt of certain countries like Greece, with Italy’s debt expected to be included in that, the general pressure on the EU is ramping up and the rating agencies are playing a central role in that pressure, as is their function.

The US Federal Reserve has taken similar measures in buying up ‘junk bonds’ in its asset-purchasing programme. Experts have noted the increasing rate of debt issuance around the investment-grade precipice, with UBS stating that European bonds rated BBB- (one notch above junk status) have risen from €330 billion in 2011 to €1.14 trillion, with BB rated bond issuance (junk status) also rising by €110 billion in that same time period; the sentiment is that the massive amounts of BBB-rated bonds could quickly become ineligible within collateral frameworks. Although the ECB has announced that so-called ‘haircuts’ will be applied to junk bonds so that their value is reduced as collateral, not many in the financial press are looking at the obvious issue. In Bloomberg, Marcus Ashworth noted that ‘as with the Fed, it’s a worrying this for the ECB to be holding ever more risky credit’. He qualifies this by saying that ‘but these are truly dangerous times for the economy. We’ll just have to fall back on the hope that these are temporary measures until the world recovers’. Whilst I am not sure I have ever read an economics paper that talks about the importance of ‘hope’ within an economic system, the situation for the EU is stark. With the central bank eating up more and more ‘risky credit’ for no other reason other than it must do so to keep up liquidity in its system, this fact when adjoined to the politically-fraught situation that is developing within the bloc regarding assistance for all of its members presents a really pivotal period for the bloc. Only this morning did Angela Merkel state that the pandemic is a threat to democracy as Europe knows it and, despite sounding particularly dramatic, she is probably right. There appears to be plenty of faith being put in the concept of ‘hope’, and also in refusing to accept the ratings of the agencies. While the agencies’ detractors will no doubt state that this is what should happen, the message the ECB is sending is rather strange – we will use the ratings during the good times, but not in the bad. The effect of that approach, both economically and politically, remain to be seen.

Keywords – credit ratings, EU, collateral, economics, finance, @finregmatters